Things Are Looking up for the Airline Sector

By George Leong, B.Comm. Published : February 21, 2008

While oil broke to $101.00 a barrel on Tuesday, the airline sector continues to struggle. Evidence of this weakness is the downward trend in the AMEX Airline Index (^XAL) since February 2007, as the barometer of airline performance is down 40% from its 52- week high. The index did make a break to the 60 level last encountered in December 2004, but it was not sustainable.

Yet, in spite of the high oil prices, we are seeing better times for airlines. Valuations are more attractive now after major restructuring initiatives have produced more efficient airlines. We are seeing a pick-up in travel, although there are competitive pricing pressures impacting margins. To counter this, rivals Northwest Airlines Corporation (NYSE/NWA) and Delta Air Lines, Inc. (NYSE/DAL) are also betting on a $20.0-billion merger that could create more efficiency and drive up the cost to fly for consumers.

The reality is that airlines as an investment at this time are still risky, as the industry fundamentals are precarious. There are better areas to invest your capital. I prefer airline makers and parts companies like The Boeing Company (NYSE/BA) and BE Aerospace, Inc. (NASDAQ/BEAV) as a play on the aviation turnaround.

On the other hand, should the situation calm down, I would favor the discount airlines.

At the top of my list is the granddaddy of all discounters and the one every player wants to emulate, Dallas-Texas-based Southwest Airlines Co. (NYSE/LUV).

Southwest Airlines started with three “Boeing 737” aircrafts in June 1971, serving Dallas, Houston and San Antonio. Today, Southwest is the dominant discount or low-fare airline in the U.S. with about 400 Boeing 737 aircraft. Its routes are focused on the U.S. and are generally short haul and high frequency, but there are long haul routes.

The carrier focuses mainly on point-to-point routes (direct non- stop city to city) rather than hub-and-spoke service (including indirect flights). This is a significant difference favoring Southwest.

In spite of the carnage in the airline industry, Southwest has been reporting some decent numbers over the past few years. Its ability to turn a profit year-after-year is impressive. Southwest has been profitable for the last 33 consecutive years. That is truly impressive.

Its low-cost structure and experience at running a discount carrier for over 20 years gives the company an advantage over other low- fare carriers and the major airlines.